Tuesday, November 25, 2008

One Small Problem

So far as I can tell, Obama's solution to the current economic problem is a "stimulus package," increased federal spending and either a tax cut or at least no substantial tax increase in the near term. The money has to come from somewhere; even allowing for the possibility that winding down the Iraq war, net of winding up the Afghan war, will free up some money, that is going to require a lot of federal borrowing.

What set off the Great Depression was a collapse of the money supply due to the failure of banks. What seems to be happening at present, to the extent that popular accounts can be believed, is a situation where it is hard for firms to borrow money--not a shortage of money but of credit. Having the government go onto the capital market and borrow an extra trillion or so in competition with other borrowers doesn't seem like a sensible way of improving the situation.

18 Comments:

This seems to be some new interpretation of classical Keynesianism, but I believe that there are also other factors at play here. Nobody really knows what Obama believes deep inside, but let's ponder that he is a progressive Democrat.

Because of the repeated rejection and suppression of the labor movement in America, and because of the gridlocked political system, the only way to achieve something like national health insurance is to do it at a time of crisis. Political change comes almost exclusively as a result of crises in this country, and not as a result of an evolution of ideas and/or public discussion.

You cannot win with ideas in a political system that only (in reality) allows two parties. That is why we don't have national health insurance, and that is why abortion has never been banned.

What set off the Depression was years of monetary expansion. The collapse was guaranteed after that. Of course it was exacerbated and extended by many factors (e.g., Smoot Hawley, higher taxes etc). But the real losses had already occurred before any banks had gone under.

Just like today, the real losses occurred before any investment banks went under. The real losses was productive capital being allocated to frivolous production such as housing construction; kinda the equivalent of digging holes and refiling them.

"Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works" --John Stuart Mill

The fact that the government is competing with other borrowers is a useful insight that isn't getting enough attention. Critics are worried about the long-term consequences of this tremendous increase in government debt (and certainly there is plenty to worry about), but there hasn't been enough discussion of the short-term consequences. The primary safe haven during this madness has been Treasuries. The bailout wizards ought to ponder what this madness might have looked like if Treasuries weren't an option?

The Chinese are also promising a 'stimulus package'. They won't have to borrow, as they have lots of assets they can sell. But those assets include U.S. Treasury securities, which may be dumped on the market just as the Treasury is increasing its new issues.

This seems to be some new interpretation of classical Keynesianism . . .

I'm not seeing the novelty.

From the Keynesian standpoint, the problem is that the Fed is pumping money into banks but the banks would rather increase their own reserves than lend money to business that are at high risk of failing in the recession. (Of course the tight credit increases the chances of business failures, making for a vicious cycle.) The Fed wants to lend the banks enough money for them to feel safe lending some of it in turn, but that would drive the prime rate down to embarrassingly low levels.

From this standpoint, the stimulus package putting upward pressure on interest rates is a feature, not a bug. It will give the Fed the pretext it needs for stepping up monetary expansion, creating 'recovery' in the form of another unsustainable boom.

"What set off the Great Depression was a collapse of the money supply due to the failure of banks."

That is so simple, so clearly established, and so universally misunderstood that I suspect the public discussion of these matters has become entirely pointless.

Of course I realize that the statements of candidates and elected officials are necessarily pure posturing. But is there anyone in government who has any conception of the underlying economic reality? If so, is there any incentive for them to act on their knowledge?

Speaking of Keynesianism, I've noticed that liberal pundits generally continue to take Keynesian ideas for granted. But how do Keynesian economists explain away the 1970s? I haven't see that discussed.

I was always under the impression that the good guys in Gov't will just order more money printed. A trillion or whatever they deem necessary to give away in all these stimulus packages/bailouts. There will be no need to borrow the money from somewhere else (China, Saudi Arabia,...) if one can simply print them instead.

There are two kinds of people in America; those who understand enough economics to realize the printing press can't cure fiscal woes, and those who think the government can provide packages like Santa Claus. Thanks to democracy, the second group is pandered to by both sides, and so we will continue to get politicians who apply their rational short-term self-interest and bankrupt the country while claiming to save it. There's no need to gnash teeth or complain; it's been this way for as long as any of us have been alive, and it will be too painful to whoever gets the levers of power to change now. Enjoy the ride!

This seems like a variant of the "crowding out" idea, right? Basically people want lower-risk investments (which is why you have to pay extra interest for riskier investments), and since they can lend their money to the Treasury at very low risk of default, they aren't lending money to safe-but-not-guaranteed borrowers like Apple or Berkshire Hathaway or whomever. Is that basically the model you've got in mind?

I wonder what the massive debt of the US and other developed countries does to the whole world's pattern of investment. It seems like it almost has to increase the risk premium paid by the next-safest investments.

It seems like a big step on the road toward this financial crisis was wherer everyone in the world suddenly realized their assessment of default risk was all wrong at the same time. Did having a clear safe-haven investment make things better at that point (because investors could at least quickly find something whose default risk they understood?) or worse (because investors could move vast amounts of money out of productive, risk-bearing investments and toward unproductive very-low-risk investments?)

David, I'm curious: What sources do you read to understand the financial crisis/economic downturn?

This seems like a variant of the "crowding out" idea, right? Basically people want lower-risk investments (which is why you have to pay extra interest for riskier investments), and since they can lend their money to the Treasury at very low risk of default, they aren't lending money to safe-but-not-guaranteed borrowers like Apple or Berkshire Hathaway or whomever. Is that basically the model you've got in mind?

I wonder what the massive debt of the US and other developed countries does to the whole world's pattern of investment. It seems like it almost has to increase the risk premium paid by the next-safest investments.

It seems like a big step on the road toward this financial crisis was wherer everyone in the world suddenly realized their assessment of default risk was all wrong at the same time. Did having a clear safe-haven investment make things better at that point (because investors could at least quickly find something whose default risk they understood?) or worse (because investors could move vast amounts of money out of productive, risk-bearing investments and toward unproductive very-low-risk investments?)

David, I'm curious: What sources do you read to understand the financial crisis/economic downturn?

From my understanding, hasn't it always been the case that when governments depart the commodity peg (e.g. gold) it's currency eventually hyper inflates?

What is different in our time to suggest anything different?

Both these questions are discussed in Milton Friedman's 1994 book Money Mischief: Episodes in Monetary History.

The answer to the first is 'yes', with the qualification that 'eventually' can be a long time.

'The first recorded "true currency," according to Liensheng Yang, author of _Money and Credit in China_ . . . "appeared in Szechuan [China] . . . during the early part of the eleventh century". It lasted for more than a century but eventually succumbed to the fatal temptation of inflationary overissue, "primarily," writes Yang, "to meet military expenditures."' (p. 190)

Another qualification is that governments have often voluntarily restored convertibility before hyperinflation set in. In the gold standard era, it was customary to suspend convertibility in wartime and restore it afterwards, sometimes with a delay. After the American Civil War, convertibility was restored in the 1870s.

On the second question, Milton Friedman argued that in a modern economy, the ability of governments to derive revenue from inflation is greatly reduced.

One reason for this, if I understand correctly, is that much of the money supply consists of debt instruments. Reductions of the value of such instruments benefit the issuers, not the government.

'Even if inflation did not reduce the ratio of the base to national income (which it unquestionably would do), a 10 percent annual increase in the base would currently yield as revenue to the U.S. government only about seven tenths of one percent of national income. Further financial innovation is likely to reduce still further the ratio of base money to national income, even aside from effect of inflation, making this source of revenue still less potent.' (pp. 255-256)

Greater market sophistication - people anticipating and adapting to inflation - also makes it harder for the government to use inflation to reduce the value of the national debt or stimulate the economy.

'Market pressures have made it difficult for governments to issue long-term debt at low nominal rates. One result in the United States was sharp reduction in the average term to maturity of the federal debt during the inflation of the 1979s - from nine years and one month for the marketable interest-bearing public debt in 1946 to as low as two years and seven months in 1976.' (p. 257)

Still, here is Friedman's bottom line: 'Nonetheless, it remains an open question whether the temptation to use fiat money as a source of revenue will lead to a situation that will ultimately force a return to a commodity standard - perhaps a gold standard of one kind or another.' (pp. 259-260)

Our present situation, with two wars and a credit crisis, does present an unusually strong temptation.

David said, "Having the government go onto the capital market and borrow an extra trillion or so in competition with other borrowers doesn't seem like a sensible way of improving the situation."

Can you (David) or someone else elaborate on this? I can guess that you are saying that the government borrowing money doesn't help others borrow money, perhaps because they are both borrowers? I thought the idea is that the government is going to somehow lend out money that otherwise would not be lent out. Can they not do that, or is that bad right now? Why is the policy not sensible according to the original post?

Question: Do banks prefer deflation or inflation now? Deflation makes a fixed rate loan more valuable, so maybe they prefer deflation. On the other hand, inflation would tend to help leveraged businesses (at the expense of bondholders) - which includes banks.

Alex said, "I can guess that you are saying that the government borrowing money doesn't help others borrow money, perhaps because they are both borrowers? I thought the idea is that the government is going to somehow lend out money that otherwise would not be lent out."

You've answered the question in asking it. The idea is that the government is going lend money to banks and others in the hopes of getting those institutions in turn to lend more money. But the government has also dramatically increased its borrowing in the form of US Treasuries, and if Obama and Congress pull off what they're promising, the borrowing will increase still further.

What may well be happening is that in the issuance of trillions of dollars in new government debt, the money that creditors might have lent to businesses and individuals is instead being lent to the US government. Anecdotal evidence suggests that those in government should look into this further. Looking at the yields on Treasuries versus corporate bonds, one can see that investors ran heavy into Treasury bonds during all this, and stayed away from corporate bonds, even as the government took dramatic action with the intent of easing the credit markets. Those actions (bailouts, looser monetary policy) have thus far been relatively ineffective, and I for one think that the flight to Treasuries might be one reason for that ineffectiveness.